Risks: Insolvency Risk and Value Maximization: A Convergence Between Financial Management and Risk Management

risks
Article
Insolvency Risk and Value Maximization: A Convergence
between Financial Management and Risk Management
Alessandro Gennaro
Department of Economics and Management, “Guglielmo Marconi” University, 00193 Rome, Italy;
a.gennaro@unimarconi.it
Abstract: This conceptual paper focuses on the relationship between insolvency, capital structure,
and value creation. The aim is twofold: to define risk-based capital measures able to absorb the
effects of financial distress and avoid corporate default; and to verify conditions and limits of use
of these measures in corporate financial policies. The capital measures based on insolvency risk
will be defined by recalling the concepts of Cash Flow-at-Risk and Capital-at-Risk. A first check
on the usefulness of these risk-based measures and their consistency with the principle of value
maximization is carried out through a simulation model. The scenario analysis allows us to examine
how financial and risk policies oriented by insolvency avoidance affect the firm value. According to
evidence from the simulation model, these measures appear to be useful in lowering the default risk,
but they require a continuous assessment of their impact on the firm value.
Keywords: insolvency risk; liquidity risk; default risk; risk capital; Capital-at-Risk; Cash Flow-at-
Risk; firm value

Citation: Gennaro, Alessandro. 2021.

Insolvency Risk and Value
Maximization: A Convergence 1. Introduction
between Financial Management and Effective assessment and management of risks are crucial for the development of
Risk Management. Risks 9: 105. companies. Not only do they make it possible to maximize the firm’s chances of survival
https://doi.org/10.3390/risks9060105
in turbulent competitive contexts, but they also increase the chances for a firm to access
sources of finance with convenient conditions (Merton 2005). Focusing on the insolvency
Academic Editors: Roberto Moro
risk, financial distress represents a situation where a firm’s operating cash flows or debt
Visconti, Salvador Cruz Rambaud
reserves are not sufficient to satisfy payment obligations. In such a situation, a firm has
and Joaquín López Pascual
to face a financial or an organizational restructuring (more or less invasive) or to proceed
with “asset fires” affecting its operating activity. If the recovery strategies are unsuccessful,
Received: 20 April 2021
Accepted: 20 May 2021
the firm loses its going concern, enters a condition of liquidation, and, in the case of asset
Published: 1 June 2021
values lower than liabilities, a condition of default emerges.
Corporate insolvency is a financial phenomenon that initially emerges as a condition
Publisher’s Note: MDPI stays neutral
of financial distress due to a shortfall of cash from current operations and a lack of liquidity
with regard to jurisdictional claims in
from external sources (e.g., credit lines). It then could evolve into a structural default in the
published maps and institutional affil- absence of changes in operating and financing policies. Financial management is therefore
iations. decisive in reducing the probability of insolvency and maximizing the attractiveness and
growth potential of a firm.
To avoid insolvency, detecting signals of economic crises or financial distress at an
early stage may not be sufficient; it is also necessary to identify “capital buffers” to cover
Copyright: © 2021 by the author.
financial needs and to absorb economic losses. An optimal capital structure in terms of
Licensee MDPI, Basel, Switzerland.
asset and liabilities composition allows the firm to reduce the risk of insolvency and to
This article is an open access article
have sufficient financial resources to absorb it. From this perspective, the choices of capital
distributed under the terms and structure are linked to the choices of working capital. Considering the risk of insolvency in
conditions of the Creative Commons the working capital optimization can contribute significantly to preventing liquidity losses.
Attribution (CC BY) license (https:// Credit and inventory management can help to reduce operational financial needs, and cash
creativecommons.org/licenses/by/ management can reduce the risk of a liquidity shortage by balancing the cash held and
4.0/). short-term debt (Ross et al. 2013).
Risks 2021, 9, 105. https://doi.org/10.3390/risks9060105 https://www.mdpi.com/journal/risks

Risks 2021, 9, 105 2 of 36
Given the above, the application of risk management logics and tools in non-financial
firms is not sufficiently covered in the financial literature to identify optimal levels of
liquidity and financial leverage that could reduce the insolvency risk through the principle
of maximizing corporate value. In the literature on corporate finance, the central topic is
generally the determination of the optimal capital structure, and the question has long
been studied assuming risk-neutral environments. Where risk management is consid-
ered, usually the link with capital structure is based on, and focused on, the agency costs
(Leland 1998). In addition, although the importance of risk management in medium and
large enterprises has significantly increased in recent decades, relatively little attention has
been paid to the definition of strategies, techniques, and tools for managing insolvency
risk, particularly in Small and Medium Enterprises, SMEs (Falkner and Hiebl 2015). This is
related to the evidence that risk management is almost never considered among the deter-
minants of treasury management, although cash holding choices represent an important
safeguard for liquidity risk (among others, Magerakis et al. 2020).
Some authors have focused on the role of the CFaR in defining limits for corporate
debt (Harris and Roark 2018). Few studies have investigated the conditions and applica-
bility of concepts such as “risk capital” or “economic capital” in non-financial companies
(Alviniussen and Jankensgard 2009).
By considering insolvency as a specific aspect of the enterprise risk, corresponding to
the probability that a condition of financial shortfall will occur, risk managers could play a
fundamental role: directly, applying procedures and tools to transfer financial and oper-
ating risks in capital or insurance markets; and indirectly, supporting financial managers
with logics and methods for defining financial policies coherent with the insolvency risk
that originates from the retained (not profitably transferable) risks.
For these reasons, this paper investigates the possible convergence between principles,
methods, and tools of risk management and financial management, in order to:
(1) define and quantify risk-based capital measures to counter the insolvency risk in
non-financial companies;
(2) verify the role they can play in financing strategies aimed at reducing the insolvency
risk, but always compatible and consistent with the principle of corporate value
maximization.
The paper therefore attempts to contribute to the identification of capital measures
for insolvency risk, analyzing the main limits to and issues with their use in corporate
financing policies.
This requires considering both financial and risk management in a “combined ap-
proach” based on simulation models for budgeting and corporate planning, estimation of
distress probabilities and default risks “embedded” in financial plans and budgets, and
risk-based capital measures for optimal liquidity and optimal financial leverage. In this
way, a firm should be able to properly calibrate its financial policies consistently with its
insolvency risk, not forgetting however to constantly monitor the impacts on value creation.
In fact, since value is based on the risk–return trade-off, it is necessary to verify
whether a risk reduction can generate a more-than-proportional reduction in expected
returns. Therefore, the principle of comparative advantage in risk-bearing (inherent in risk
management) should be closely related to the principle of shareholders’ value maximization
(inherent in financial management) in order to provide effective guidance on optimizing
insolvency risk and the financial structure.
The rest of the paper is organized as follows. A literature review on insolvency risk
and financial management, risk-based capital and risk management, and firm value and
capital structure is presented in Section 2. Specific measures of risk capital for insolvency
risk are presented in Section 3. The paper then goes on with the analysis and discussion
of the results of their application in a simulation model in Section 4. Final remarks on
corporate financing policy, limitations of the study, and future research suggestions are
shared in Section 5.
Risks 2021, 9, 105 3 of 36
2. Literature Review and Theoretical Framework

Corporate insolvency can affect a wide range of fields in economic science (economic
policy, corporate strategy and organization, finance, legal) and involves several practition-
ers (lawyers, accountants, managers, directors, etc.). Different definitions of insolvency
can be found in each of these fields, depending on the specific perspective with which it is
analyzed and addressed (Newton 2009).
In the financial literature, the relationships between insolvency risk, financing policies,
and firm value have been deeply investigated.
The concept of insolvency has been defined in terms of both stocks and flows
(Ross et al. 2013). A flow-based insolvency is connected to a condition of financial dis-
tress and occurs when operating cash flows are not sufficient to meet current obligations.
A stock-based insolvency is related to a condition of financial default, and emerges when
a firm has negative net worth, i.e., the value of assets is lower than the value of debts.
Furthermore, by associating the concept of insolvency with those of monetary and financial
equilibrium, principles and logics of corporate financial management (cash management,
working capital management, capital management) have been defined to maintain and
strengthen the solvency of a firm. In particular, three branches of studies have been devel-
oped.
The first concerns prevention of insolvency. The literature on business failure pre-
diction methodologies is huge and substantial, ranging from discriminant analysis to
conditional logic models and neuronal networks (Appiah et al. 2015; Shi and Li 2019).
Moving from the well-known Altman’s approach, specific models for SMEs (Roggi 2016)
and large companies (Barbuta-Misu and Madaleno 2020) have been proposed and tested.
These methods are normally conditioned by the size and composition of the sample, and
they do not always allow for an exact identification of risk indicators and safety levels,
useful for orienting corporate financial policies.
The second one is about the relationships between capital structure, default risk, and
value creation. The influence of financing policies on corporate value has been extensively
studied in the financial and managerial literature. As established by the well-known “M&M
propositions” (Modigliani and Miller 1958, 1963), financing policies determine the firm’s
financial risk and financial leverage shifts the costs of capital and affects the firm value.
However, two conceptual models specifically consider the link between insolvency risk and
capital structure, highlighting the relevance of corporate financing policies. The first one is
the Trade-off Model (TOM), which makes a distinction between operating and financial risk
and between levered and unlevered value, considering disruption costs and distress costs
related to financial debt (Copeland et al. 2005). The TOM affirms the existence of an optimal
financial structure reachable by balancing advantages (tax savings) and disadvantages of
debt (bankruptcy costs; agency costs). In fact, thanks to the tax shield, an increase in debt
initially causes a growth of firm value, with the unlevered value remaining flat. Beyond
a certain level of leverage, which maximizes FVL , a further increase in debt would lead
to a reduction in the firm value because of the rising default probability and related costs.
Optimal leverage tends to vary over the lifecycle of a company (birth, growth, maturity,
and decline). Each phase is characterized by different levels of financial distress, insolvency
risk, and recovery probability, and therefore influences financing policies and changes in
the capital structure of a firm (Koh et al. 2015). The relationship between optimal capital
structure and cash flow risk has also been explored. Several studies focused on the role of
systematic risk, finding that firms with riskier assets choose a lower net leverage, given
their higher expected financing costs; less risky firms, with lower expected financing costs,
optimally choose to issue more debt to exploit a tax advantage (Palazzo 2019). Other studies
focused on the role of operating leverage as a risk factor, finding that firms with lower levels
of operating cash flow have a positive and significant relationship between cash flow risk
and debt levels, while firms with higher levels of operating cash flow have no significant
relationship between cash flow risk and debt levels (Harris and Roark 2018). Limits of
the TOM for practical uses are several. The identification of an optimal structure requires
Risks 2021, 9, 105 4 of 36
an estimation of the default probability, related costs, and methods to be considered in

the firm valuation process. With regard to the costs of default, an extensive literature is
available on the subject, from which it can be inferred that these can vary widely according
to industries, kinds of crisis, recovery strategies, methodologies applied, and measurement
bases. The magnitude of direct costs of default seems to range from 3% to 5% of the firm
(liquidation) value; that of indirect costs from 10% to 25% of the firm (economic) value
(among others, Farooq and Jibran 2018). Regarding valuation problems, several ways to
adapt the discounted cash flow model to a potential distress situation have been proposed
(Damodaran 2006): through simulations; by bringing in the effects of distress into both
expected cash flows and the discount rate; and by dealing with financial distress separately.
The second conceptual model is the option pricing model, OPM (Black and Scholes
1973; Merton 1974), according to which corporate securities can be considered as options on
the firm’s assets. In this view, the “put-call parity” allows for debt capital to be expressed
as a risky security whose current value would equal the difference between its face value,
D, and the value of the put option held by the shareholders on the firm’s assets. Since the
price of the put option is positively related to the standard deviation of the asset value and
to the level of debt in the capital structure, the OPM has the advantage of highlighting the
relationship between corporate solvency and variability in expected operating results. In
fact, the firm value is normally considered a stochastic variable that, according to the theory
of finance, changes over time following a geometric Brownian motion (Copeland et al. 2005)
generated by the uncertainty—measured in terms of standard deviation—of the operating
rate of return.
A third line of studies examine the role and techniques of risk management and its
interactions with other areas of management. Over the last few decades, corporate risk
management has been studied for its strategic role in creating corporate value, becom-
ing the means to better deal with turbulent business conditions. In fact, the ability to
respond effectively to the often-dramatic environmental change represents an important
source to strengthen competitive advantage and protect the integrity of a firm’s invested
capital (Andersen and Roggi 2012). By adopting a “holistic approach” (corporate risks
are managed together in a coordinated and strategic way), the so-called Enterprise Risk
Management (ERM) reduces the volatility of operating cash flows, thereby reducing the
probability of liquidity shortfalls and insolvency risk (Nocco and Stulz 2006), and increasing
corporate value by lowering the operating cost of capital (Doherty 2005; O’Brien 2006).
It is useful, for the purposes of this paper, to highlight three main areas of CRM studies:
(1) measurement of corporate risk;
(2) quantification of risk-based capital; and
(3) simulation methods for financial planning and financial budgeting.
(1) The risk management literature provides several peculiar risk-based measures
to assess corporate risk and its impact on invested capital. Among them, relevant in the
prevention of financial default are Value-at-Risk (VaR) and Cash Flow-at-Risk (CFaR).
Initially defined to deal with the market, credit, and operating risks of financial
firms, the logic of VaR has been also applied to non-financial firms, generating alternative
measures such as Earnings-at-Risk, Capital-at-Risk, and Cash Flow-at-Risk. The latter
indicates the maximum cash shortfall that a firm is willing to accept, with reference to a
given confidence level. Stein et al. (2001) developed a measure of CFaR defined as the
probability distribution of a company’s operating cash-flows over some horizon in the
future, based on available information. While easy to define, it is difficult to estimate a
reliable CFaR for a company; the authors propose to apply a top-down method in which
the ultimate item of interest is the variability of a firm’s operating cash-flows, which should
summarize the combined effect of all the relevant risks a firm is facing. Andren et al. (2005),
recalling the limits of the bottom-up (RiskMetrics 1999) and top-down (Stein et al. 2001)
methods for calculating the down-side risk (Nawrocki 1999), propose the “Exposure-Based
CFaR”, an alternative measure compatible with both global and conditional CFaR that
provides an estimated set of coefficients able to supply information on how macroeconomic
Risks 2021, 9, 105 5 of 36
and market variables can influence the company’s cash flow. This makes it possible to
explain the variability of cash flows according to the various risks, and hence to foresee
whether a hedging contract or a change in the financial structure can influence the risk
profile of a company. Jankensgard (2008) puts CFaR among the measures related to debt
capacity; these can guide risk management strategies by indicating whether a risk hedge
has lower costs than the benefits of reducing volatility, acting as a substitute for equity
capital. This seems to recall the fundamental principle by which a lower cash flow volatility
reduces the needs for liquidity buffers and equity reserves, releasing funds for alternative
business investments with higher returns (Merton 2005).
(2) Studies and practices of CRM help managers to acknowledge that, unfortunately,
companies take many strategic or business risks that cannot be reduced or transferred
in a profitable way using insurance or financial markets. Therefore, the purpose of risk
management can be summarized in an ex ante estimate of the capital amount exposed to
the specific risks of the activities carried out by a company (Forestieri and Mottura 2013).
From this perspective, specific measures of capital have been developed to face the different
types of corporate risks, mainly in financial companies and institutions. More specifically,
measures such as Economic Capital and Risk Capital have been used to assess how well a
firm is equipped to resist losses. They represent an internal estimate of the equity capital
needed by a financial institution to face the risks to which it is exposed, allowing it to absorb
the expected economic losses in a given time with a given confidence level (Hull 2018).
They are also useful to define the amount of equity capital that a firm needs to survive a
worst-case scenario by absorbing the economic losses of that scenario (stress test).
The concept of risk capital (RC) was initially introduced and used for risk management
in financial companies (Merton and Perold 1993). Applied also in non-financial companies,
the RC has taken on the more general meaning of the financial resources (not only equity)
a firm can use, preserving solvency and assets, to absorb the full brunt of market failures,
strategic misjudgments, business uncertainties, and adverse circumstances. In other words,
RC represents the capital that can be used to finance unexpected losses. Its usefulness
for risk management in non-financial firms is still subject to analysis, as confirmed by
Wieczorek-Komsala (2019), which relates RC to a sustainable development based on a triple-
bottom-line of performance (people, planet, and profit). As for the scale and components
of the RC, its size is reported to depend on strategic and operating risk management
choices, and its main components are liquidity endowment, unused collection capacity,
insurance, and financial coverage (Conti 2006). Another peculiar component is the so-called
“contingent capital”. It combines the functions of raising capital and risk management,
allowing companies to issue new capital (equity, debt, or hybrid securities) over a given
period of time, usually at a pre-defined issue price and as a result of losses from pre-
specified risks (Culp 2002). It represents one way (two other ways being the transfer of risk
via insurance or derivatives, and the raising of additional capital) of managing business
or financial risks. Contingent capital is essentially a type of option on financial capital, by
which a company pays the investor a fixed price or a premium for the right (but not the
obligation) to issue paid-in capital at a later date. Such capital, lightening the balance sheet
by limiting the paid-in capital, helps to reduce the overall cost of capital and to increase the
firm’s value. The main contingent capital facilities are letters and lines of credit, contingent
equity, committed long-term capital solutions, reverse convertibles, contingent surplus
notes, and puttable catastrophe bonds.
(3) Over the last three decades, relations and interactions between financial manage-
ment and risk management have been deepened (Froot et al. 1993). A separate approach
to these branches would not consider the effects of risk treatment choices on financial
structure, and vice versa. The benefits of a simulation of the expected results based on
probabilistic distributions have been known since Hertz’s seminal works (Hertz 1964, 1968).
Enterprise Risk Budgeting (ERB) uses probabilities and simulations to build financial plans
and budgets consistent with the logics of risk management. This allows us to implement
the concepts of total risk, risk universe, risk capacity, risk profile, and risk optimization
Risks 2021, 9, 105 6 of 36
(Alviniussen and Jankensgard 2009). Considering the total risk as the risk of failing impor-
tant objectives and experiencing financial distress, the use of a simulation methodology
allows for a risk optimization, which consists of the reciprocal adaptation of the risk profile
to the risk capacity. The latter is thought of as the financial resources a firm needs to survive
in difficult times without making costly adjustments to its business activities. The concept
of risk capacity is similar to that of risk capital, being it a function of liquid assets, spare
debt capacity, and hedge positions.
3. Risk Capital and Firm Value: Specific Configurations for Insolvency Risk
We model two measures of risk capital, the Liquidity Risk Capital and the Equity Risk
Capital, considering specific definitions for distress risk and default risk, and focusing on
the variability in operational cash flows in the short and medium to long term. To apply
the VaR logic, a normal distribution of the expected cash flows is assumed, in order to link
the risk capital measures and the firm’s risk tolerance through predefined confidence levels.
The probabilities of financial distress and financial default deriving from the model are
then used to adapt the firm value estimation to the insolvency risks and costs.
3.1. Definition of Insolvency, Distress, and Default

Insolvency is the pathological condition in which a firm is structurally unable to meet
its commitments and obligations to its creditors (employees, suppliers, financiers, and
governments). It is possible to distinguish a temporary insolvency (financial distress),
linked to initial phases of a corporate crisis, from a structural one (financial default) due
to the worsening of the corporate crisis. Financial distress relates to a situation where a
firm’s operating cash flows and liquidity are not sufficient to satisfy contractual obligations
(payment of current expenses or interests, repayment of commercial or financial debts.). If
this situation is due to contingencies, such as the typical seasonality of revenues, it can be
removed: in a contingent way, through “fire sales” of surplus assets or operating assets; or in
a strategic way, by rethinking the working capital policies or reviewing the level of liquidity.
If the financial distress is not due to contingent factors but caused by a structural condition
of exceeding debt with respect to the levels of operating profitability, it can be overcome
through a review of capital structure policies. In this case, a financial restructuring is
required, accompanied by a strategic turnround if the firm’s operating margins are too
low or negative. Without corrective actions, the distress becomes structural and evolves
into financial default. If the firm’s competitive resources and business prospects make
turnaround and restructuring impossible (or useless), a default may require a declaration
of bankruptcy, which generates relevant economic losses for all of the stakeholders.
That said, the following configurations of risk can be highlighted:
- distress risk, which is the probability a condition of financial distress occurs due to
a temporary shortfall of cash and a lack of contingent capital available to cover the
excess of financial needs;
- default risk, which is the probability that a situation of financial distress becomes
structural and evolves into a condition of financial default, where an equity lack
results in a lower recoverable amount of asset sales than the face value of corporate
liabilities.
3.2. Optimal Capital Structure

In this conceptual framework, an optimal corporate financial policy should define
levels of liquidity (asset side) and equity (liability side) bearing in mind the link between
insolvency risk and value creation, and therefore between risk management and financial
management.
This means that the cash-to-assets ratio is linked to debt, and therefore firm liquidity
assumes a rather different role from those usually recognized and analyzed in the financial
literature (Graham and Leary 2018; Nikolov et al. 2019).
Risks 2021, 9, 105 7 of 36
In this field, the search for an optimal capital structure becomes a balancing problem of
liquidity and leverage. Liquidity is linked to the cash, cash equivalents, and debt reserves
of a firm, while leverage is linked to the outstanding financial debt and paid-in equity
capital (increased by retained earnings); both are affected by the firm’s financial dynamics.
The risk and magnitude of insolvency depend on the liquidity and the financial leverage of
the firm. The level of liquidity is adequate when the firm can meet its obligations promptly
and economically; the financial leverage is sustainable when the return and value of the
assets are higher than the cost and value of the liabilities (Forestieri and Mottura 2013).
Therefore, solvency is linked to the composition of the company’s capital structure, both in
terms of assets (adequate liquidity level) and liabilities (adequate financial leverage). In fact,
the same risk factor, affecting the variance in operating cash flows, produces an exposure to
distress or default risk that is more significant the less liquidity is allocated and the greater
the leverage. This affects both the financing policy and the risk management approach
of the firm; once the risk treatment possibilities have been exhausted, the containment of
exposure to insolvency risk requires action on the company’s asset structure, varying the
leverage or the liquidity endowment (Conti 2006).
Optimal financial policies, decisive in reducing the insolvency risk, are those allowing
a firm to maintain an adequate level of liquidity and equity sufficient to face the occurrence
of a financial distress and avoid a default scenario. This would integrate the typical process
of risk management (assessment, analysis, and treatment via transfer, hedging, or hiring),
aiming to define levels of leverage and liquidity coherent with the risk profile of a firm.
3.3. Risk-Based Capital Measures

Optimizing the capital structure then requires peculiar configurations of Risk Capital
to cover the distress risk and the default risk defined above.
To quantify the financial resources a company needs to absorb a financial distress,
we consider that corporate solvency is guaranteed when the following two conditions are
steadily met:
- the operating cash flow generated by the company in a given period and available to
lenders (cash flow to firm, CFF) is equal to, or higher than, the cash flow to service the
debt in the same period (cash flow on debt, CFD);
- if the previous condition is not met, the firm’s solvency is still guaranteed when liquid
assets (cash and cash equivalents), increased by the contingent capital (mainly debt
reserves), are equal to, or higher than, the lack of CFF, which does not allow the firm
to fully cover the CFD in a given period.
The first condition deals with the risk of a cash shortfall, which is normally addressed
by optimizing the equilibrium between operating inflows and outflows; the second one
deals with the liquidity risk. Both can be treated in a probabilistic way, coherent with the
ERM, considering the future cash flow of a given period as the expected value of random
variables with a certain probabilistic distribution.
To quantify how much capital should be allocated to cover the liquidity risk, the VaR
logic could be applied to estimate the Liquidity Risk Capital (LRC)—i.e., the optimal level
of liquidity—on the basis of a certain level of confidence. Two basic choices must be made:
- firstly, whether to consider negative CFF (financial operating losses) or results lower
than certain safety thresholds (negative deviations);
- secondly, how to consider the probability distributions for the expected cash flows.
Since CFF is a random variable, the CFaR is defined as the difference between the ex-
pected cash flow, for which a normal distribution is assumed, and the cash flow associated
with a chosen confidence level:
CFaRαt = E(CFFt ) − Eα (CFFt ) (1)
The CFaR is not a measure of distress risk because it actually does not indicate the
ability to remunerate or repay loans. It is therefore necessary to define a risk measure
Risks 2021, 9, 105 8 of 36
according to a specific threshold. The Liquidity Risk Capital, LRCt α , is defined as the
difference between the cash flows serving the debt, CFDt , and the minimal expected cash
flows with a given confidence level α, Eα (CFFt ):
LRCtα = CFDt − Eα (CFFt ) (2)
with
LRCtα ∈ [0; CFDt − Eα (CFFt ))
If the CFD is also a random variable (Normally, a relevant portion of financial debt,
especially if short-term, is of the contingent capital type, as in the case of credit lines or
advances on commercial invoices. In this case, the flows of repayments and interests for a
given period are random variables, because they are related to operating cash flows.), a
measure of the LRC based only on the variability of CFF may be incorrect; it is necessary to
consider the expected surplus/needs of financial resources (FSN) for a given period, equal
to the difference between the expected CFF and the mandatory payments (interest expense
accrued, amortization plans, repayments of conditional loans) in the same period. A
negative difference means that the business does not produce sufficient cash, and contingent
financial resources are needed.
Therefore, by setting the threshold equal to zero, the optimal LRC will be equal to:
LRCtα = − Eα ( FSNt ) (3)
with
LRCtα ∈ [0; − Eα ( FSNt ))
Optimal LRC is a function of the variability of FSN and the chosen confidence level:
LRCtα = f ( EFSNt ; SDFSNt ; α)
The surplus or financial needs in a given period t (month or year) depend on Ebitda,
taxes, changes in net working capital, capital expenditures, and mandatory repayments on
financial debt:
FSNt = Ebitdat − Taxest − ∆nwct − Capext − Mrt
Indicating with Ebitda* the Ebitda after taxes, the variance in FSN could be expressed
in this way:
VAR FSNt = VAR Ebitda∗t − VAR∆nwct − VARcapext − VARmrt

+COVEbitda∗t ,∆nwct + COVEbitda∗t ,Capext + COVEbitda∗t ,Mrt
+COV∆nwct ,Capext + COV∆nwct ,Mrt
+COVCapext ,Mrt
Definitely, LRC depends on:

- market dynamics, the operating leverage degree, fiscal policies;
- working capital management and commercial policies;
- investment policies;
- financing policies; and
- the correlation degree between investing and financing policies and operating margin.
The available LRC is instead defined as the sum of the cash and cash equivalents at
the beginning of a given period, C&CEt− 1 , and the debt reserves available during the same
period, DR:
LRCtav = C&CEt−1 + DRt (4)
An open question is whether the financing facilities linked to a firm’s revenues or
margins (e.g., advance financing of invoices (For example, an advance financing of invoices
requires new revenues, and in the event of a reduction in turnover it involves financial
Risks 2021, 9, 105 9 of 36
needs (i.e., repayments on invoices advanced in previous periods exceed the advances of
new invoices).)) should be included among the debt reserves. A prudential approach to
the estimation of LCR would suggest a negative answer; however, this would lead to a
quite systematic over-estimation of the liquidity risk, and to a LRC exceeding the actual
operating needs.
Needs or surplus of risk capital to face the liquidity risk are determined by the
difference between available LCR and optimal LRC (with respect to a certain confidence
level):
LRCtn/s = LRCtav − LRCtα (5)
A LRCs/n less than 0 denotes a deficit of liquidity not sufficient to entirely cover the
financial repayments related to a certain percentile (95th or 99th) of financial needs in a
given period. Conversely, if LRCs/n is positive, it denotes a surplus of liquidity with respect
to the financial repayments related to a certain percentile (95th or 99th) of financial needs
in a given period. Furthermore, LRCs/n implicitly provides information on the probability
of financial distress of a given period (see Table 1).
Table 1. Liquidity Risk Capital and implicit probability of financial distress.
Risk Capital Probability of Financial Distress

LRCtn/s >0 pd = P( FSN ≤ 0) < α
LRCtn/s =0 pd = P( FSN ≤ 0) = α
LRCtn/s >0 pd = P( FSN ≤ 0) > α
The ratio between the available and optimal LRC is a “resilience index” and measures
the ability of a firm to withstand periods of a shortfall in cash. Being a ratio between a
stock and a flow, the resilience index measures the number of periods in which a firm can
use its liquidity (cash and debt reserves) to cover financial needs for debt repayments:
LRCtav
irtα = (6)
LRCtα
The default risk emerges by considering whether the operating results are sufficient
over time to repay and remunerate financial debts. This condition could be analyzed
in terms of present values of assets and debts: the going concern is economically and
financially sustainable when the economic value of firm assets (The “economic value”
corresponds to the present value of future cash flows generated by the asset in place and
growth opportunities, considering an “ongoing concern” hypothesis.) (FVgc ) is equal to,
or higher than, the face value of the financial debt (FD). A lower FVgc than FD indicates
an excess of debt, which absorbs much more cash flow than that the core business can
structurally generate.
The assessment of the economic values’ dispersion, in a going concern hypothesis,
allows for the measurement of default risk. A stochastic approach requires us to consider
FV as a random variable for which a probabilistic distribution is assumed. In this way,
the CaR can be calculated as the difference between the estimated value of a firm (the
expected value of a probabilistic distribution of alternative values), and its economic value
corresponding to a given confidence level:
h i
gc
CaRαt = E( FVt ) − max Eα FVt ; 0 (7)
The CaR indicates the expected loss of the firm’s economic value due to the fact that
competitive scenarios may arise in which the firm, while maintaining the going concern,
will generate unsatisfactory financial performances. If the residual firm value is lower than
the outstanding financial debt, both shareholders and creditors would have no interest
(except in the case of a moral hazard) in the going concern; they could then take action to
Risks 2021, 9, 105 10 of 36
put the company into a restructuring process or a liquidation process (A firm value lower
than financial debt indicates, in a going concern scenario, returns on equity lower than the
cost of equity. This could lead the shareholders to opt for a business interruption and a
corporate liquidation.).
The equity capital that should be allocated to cover the risk of restructuring or a
business interruption should be quantified by moving from the CaR to a peculiar measure
of Economic Risk Capital (ERC). Assuming that FV, in a going concern scenario, cannot
be less than zero, an optimal level of equity risk capital, ERCα , given a certain confidence
level, will be: h i
gc
ERCtα = FDt + NWt − max Eα FVt ; 0 (8)
Optimal ERC is a function of the financial leverage and the variability in FV, which
depends on the variability of CFF, the cost of capital, and the company lifetime:
ERCtα = f ( ECFFt ; SDCFFt ; α; wacc;)
Annual cash flows to firm depend on Ebitda, taxes, changes in net working capital, and
capital expenditures:
CFFt = Ebitdat − Taxest − ∆nwct − Capext
Indicating the Ebitda after taxes as Ebitda* , the variance in CFF could be expressed
as follows:
VARCFFt = VAR Ebitda∗t − VAR∆nwct − VARcapext
+COVEbitda∗t ,∆nwct + COVEbitda∗t ,Capext
+COV∆nwct ,Capext
Definitely, ERC also depends on:
- market dynamics, the operating leverage degree, fiscal policies;
- working capital management and commercial policies;
- investment policies;
- financing policies; and
- the degree of independence of investment and financing policies with respect to
operational and working capital management choices.
Therefore, since the available equity risk capital is the net worth, the needs (or surplus)
of equity risk capital, ERCt s/n , will be:
h i
gc
ERCts/n = FDt − max Eα FVt ; 0 (9)
Notice that a risk capital lack may not require a corresponding equity capital increase.
If the net invested capital remains flat, a full coverage of the business interruption risk
requires approximately additional equity—to replace debt—equal to half of the estimated
risk-capital needs.
Similarly, ERCs/n implicitly provides information on the probability of financial default
in a going concern scenario (see Table 2).
Table 2. Equity Risk Capital and implicit probability of default.
Risk Capital in a Going Concern Probability of Default

ERCtn/s > 0 p D = P( FV gc ≤ FD ) < α
ERCtn/s = 0 p D = P( FV gc ≤ FD ) = α
ERCtn/s > 0 p D = P( FV gc ≤ FD ) > α
Given a certain likelihood of business interruption, the firm’s solvency in a liquidation

process is still guaranteed when the current value of assets (FVlc ), reduced by potential
Risks 2021, 9, 105 11 of 36
liabilities, is overall equal to, or higher than, the FD. The current value corresponds to the
sum of market value, obtained through “fire sales”, of each asset in place considering a
“liquidation” hypothesis. In such a scenario, a risk capital measure must indicate the equity
necessary to guarantee the repayment of financial debts through a total asset liquidation.
This explains why FV must be also estimated in a liquidation hypothesis. In this case, the
CaR is defined as the difference between the estimated value of a firm (the expected value
of a probabilistic distribution of alternative liquidation values) and its liquidation value
corresponding to a given confidence level:
h i
CaRαt = E FVtlc − max Eα FVtlc ; 0 (10)
In this case, CaR indicates the expected loss of the firm’s value due to the liquidation
process. If the loss in asset value is such that the residual firm value is lower than the
outstanding financial debt, a risk of potential bankruptcy emerges. To quantify the capital
that should be allocated to cover this risk, the specific measure of Economic Risk Capital
(ERC) will become the following:
h i
ERCtα = FDt + NWt − max Eα FVtlc ; 0 (11)
Since the equity capital is the right buffer to cover the expected economic losses in a
liquidation process, the surplus or needs of ERC will be:
h i
ERCts/n = FDt − max Eα FVtlc ; 0 (12)
Once again, ERCs/n implicitly provides information on the probability of bankruptcy

in a liquidation scenario (see Table 3).
Table 3. Equity Risk Capital and implicit probability of bankruptcy.
Risk Capital in a Liquidation Concern Probability of Bankruptcy

ERCtn/s >0 pb = P FV lc ≤ FD < α

ERCtn/s =0 pb = P FV lc ≤ FD = α

ERCtn/s >0 pb = P FV lc ≤ FD > α
In order for risk-based capital measures to be useful in setting up decision-making

models for corporate financing policies, a firm should adopt:
(1) forecasting methodologies (for budgeting and planning) coherent and connected with
the VaR logic; and
(2) valuation methods that explicitly consider the risks and costs of insolvency.
(1) When the VaR logic is applied to calculate LRC and ERC, two main choices are
needed: the approach to the expected losses (parametric or non-parametric); and the form
of probability distribution (normal, log-normal, binomial, etc.). Such choices affect (even
significantly) the measure of risk-capitals and must be consistent with the forecasting
procedures (Monte Carlo or scenario; build-up or pure probabilistic) adopted by the firm.
The build-up approach requires us firstly to calculate the mean expected values of the
elementary variables (revenues, costs, BCC, etc.), and then to determine the financial results
by composing those expected values. The pure probabilistic approach requires us firstly to
calculate the alternative financial results in each scenario, and then to determine the mean
expected values.
Financial planning and budgeting must clearly consider the variability in the expected
flows in each period within the forecasting horizon (short-term, medium to long term). To
depict the probabilistic distribution of expected cash flows, different approaches are avail-
able. The “scenario approach” is normally associated with a representation of alternative
Risks 2021, 9, 105 12 of 36
cash flows in a limited number of scenarios (normally the triad “pessimistic–expected–

optimistic”), each of which is attributed a (subjective) probability of occurrence. In this case,
the results are affected by the decision maker’s discretion in assessing the company’s ability
to adapt to various contexts (alternative scenarios) and to achieve the planned results. The
“Monte Carlo approach” is instead based on random generation procedures that give lots
of values for each of the elementary variables that determine the expected cash flows. In
this case, the results depend on how either the behavior of the input variables (normal or
non-normal; subjectivist or frequentist probability distribution), the correlations between
the input variables, and the cause–effect relationships (linear or non-linear) are defined.
Although the “Monte Carlo approach” allows us to better simulate the continuity of a
firm’s variables and values, the “scenario approach” allows us to better represent the firm’s
flexibility and resilience within unfavorable competitive conditions.
The VaR methodology allows for both a parametric and a non-parametric approach.
The first one has the limit of approximating with linear relationships the real (non-linear)
relationships between financial figures and risk factors. However, it also has the advantage
of simplicity: the average and standard deviation of expected results are sufficient to
describe the shape of the probability distribution of the variables considered. Therefore, the
parametric approach allows us to apply the VaR methodology in a subjectivist perspective;
that is, through: the construction of alternative scenarios, the assignment of subjective
probabilities of occurrence, and the calculation of variability indexes of relevant results
and values.
(2) Any deficit or surplus in risk capital should guide the firm’s financial policies and
suggest to the Chief Financial Officer proper adjustments to the capital structure. However,
the resulting optimization process cannot only consider the minimization of the insolvency
risk but also the related effects in terms of firm value. Indeed, variations in the liquidity
degree of assets change the risk and profitability of the net invested capital, and variations
in financial leverage change the cost–benefit tradeoff of financial debts. Therefore, the
search for an optimal capital structure is a problem of a continuous search for balance
between the insolvency risk consistent with the expectations of lenders and the value
creation prospects consistent with the expectations of shareholders.
3.4. Firm Value and Insolvency Risk

Consistently with financial theory, it must be considered that a financial distress in-
volves costs related to financial restructuring procedures, while a financial default involves
costs related to bankruptcy procedures. In a going concern hypothesis, the distress (direct
and indirect) costs, whose incidence on firm value is δd , will occur with a probability of pd ;
the firm value will be:
gc
FV gc = E FVt · 1 − pd ·δd (13)
In a liquidation hypothesis, the bankruptcy (direct) costs, whose incidence on firm

value is δb , will occur with a probability of pb ; the firm value will be:

FV lc = E FVtlc · 1 − pb ·δb (14)
Therefore, the firm value will be a weighted average between the going concern value
and the liquidation value, where the weights are based on the probability of default.

FV = FV gc · 1 − p D + FV lc · p D (15)
4. Scenario Analysis and Simulations: Methodology and Results

The validation of the risk capital measures proposed above appears complex through
empirical analysis. While it would be useful to test the effectiveness of LRC and ERC
on actual firms, the nature of risk-capital measures makes an empirical analysis difficult
to carry out. Such an analysis would require information on forecasting data (plans and
Risks 2021, 9, 105 13 of 36
budgets) and on the financial flexibility of a company. Any information lack could influence
the estimation of LRC and ERC and the assessment of their effectiveness. Moreover,
deriving the performance variability from historical trend analysis may not allow us to
take into account the strategic/operating flexibility separately from financial flexibility, the
firm’s approach to risk management, and other relevant variables.
For this reason, it appears appropriate to approach the check of the usefulness of LRC
and ERC through a forecasting and simulation model that allows for analyzing the effects
of the variability in operating cash flows on liquidity and solvency. Expected cash flows
are estimated based on the following equations:
CFFt = Ebitda∗t − ∆nwct − Capext (16)
FSNt = Ebitda∗t − ∆nwct − Capext − Mrt (17)

with:
Ebitda∗t = [ Revt ·(1 − v ) − Foct ]·(1 − τ ) (18)
being:
- Revt the turnover in period t (month or year);
- v the variable operating costs on revenues ratio;
- Foct the fixed operating costs; and
- τ the corporate tax rate.
By applying the Equation (17), expected Ebitda* are estimated in various alternative
scenarios, each characterized by a different growth rate of revenues. We assume the
invariance of v and τ (fixed costs are invariant by definition) among the different scenarios;
in this way, the variance of Ebitda* depends on the variability of revenues, and its magnitude
is explained by the operating leverage and the tax rate:
VAR Ebitda∗t = [SDRevt ·(1 − v )·(1 − τ )]2 (19)
Recalling then the Equation (16), the assumptions of invariance of working capital
policies and independence of investment policies from revenues’ variability make the
VARCFF strictly dependent on the variability of revenues. The distribution of alternative
revenue growth rates is modeled through a Monte Carlo simulation, assuming a normal
form of probability distribution and making a specific hypothesis about the mean and
standard deviation of the growth rate. Therefore, the simulation and forecasting model
focuses on the effects of the main source of business risk (uncertainty of sales) on firm
liquidity and solvency, allowing us to size the risk capital with respect to this factor of risk.
In each alternative scenario, financial budgets and financial plans reflect the outcomes
of the forecasting model; the same model is used to simulate the effects on a firm’s cash
flows, the liquidity and solvency of the alternative hypothesis of capital structure (4), and
financing strategies (3).
The analyses and comparison of the results obtained by combining alternative cap-
ital structures with alternative financing strategies (12 combinations) allow us to verify
the behavior of LRC and ERC and their usefulness in reducing the risk and probability
of insolvency.
4.1. Parameter Values

The model simulates the financial plan (5 years) and the treasury budget (12 months)
of a firm with the following operating characteristics: an annual capital turnover of 90%;
variable costs on revenues of 40%; fixed costs on net invested capital of 35%; a depreciation
rate for fixed assets of 10%; annual capital expenditure equal to annual depreciations; Days
Sales Outstanding equal to 60 days; Days Payable Outstanding equal to 30 days; and a tax
rate of 25%.
4.1. Parameter Values
The model simulates the financial plan (5 years) and the treasury budget (12 months)
of a firm with the following operating characteristics: an annual capital turnover of 90%;
Risks 2021, 9, 105 variable costs on revenues of 40%; fixed costs on net invested capital of 35%; a depreciation
14 of 36
rate for fixed assets of 10%; annual capital expenditure equal to annual depreciations;
Days Sales Outstanding equal to 60 days; Days Payable Outstanding equal to 30 days; and
a tax rate of 25%.
The expected
The expected earnings
earnings and
and cash
cash flows
flowsat
atthe
theend
endofofeach
eachyear
yearwere
wereobtained
obtainedthrough
througha
Monte Carlo simulation assuming a normal distribution for the growth rate,
a Monte Carlo simulation assuming a normal distribution for the growth rate, withwith the mean
the
and standard deviation shown in Table 4.
mean and standard deviation shown in Table 4.
Table 4. Annual growth rate of revenues in alternative scenarios.
Table 4. Annual growth rate of revenues in alternative scenarios.
Years
Years
Growth
GrowthRates
Rates 1 1 2 2 3 3 4 4 5 5 LTGR
LTGR
Expected
Expected 2.0%2.0% 4.0%4.0% 4.0%4.0% 3.0%
3.0% 1.0%
1.0% 1.0%
1.0%
Standard
StandardDeviation
Deviation 3.0%3.0% 3.0%3.0% 3.0%3.0% 3.0%
3.0% 3.0%
3.0% 3.0%
3.0%
The
The random
random revenue
revenue generation
generation process provided 1000 alternative annual growth
rates,
rates, each
each of
of which
which is attributed
attributed a probability
probability of occurring
occurring on the basis of its frequency
(see Figure 1).
Figure
Figure 1.
1. Probabilistic
Probabilistic distribution
distribution of
of the
the first
first year
year growth rate.
growth rate.
The forecasting model

The forecasting modelalso
alsoconsiders
considers seasonality
seasonality to model
to model the the financial
financial budgeting
budgeting (see
(see
TableTable
5). 5).
Table 5. Seasonality of annual revenues.

Seasonality
Seasonality
Months 1 2 3 4 5 6 7 8 9 10 11 12 FY
MonthsExpected 1 8% 2 5% 310% 411% 512% 610% 7 8% 8 6% 9 9% 107% 118% 12 6% FY
100%
Expected 8% 5% 10% 11% 12% 10% 8% 6% 9% 7% 8% 6% 100%
4.2. Base Case
The Case
4.2. Base capital structure of the firm is initially composed by equity (25% of the Net
The capital structure of the firm is initially composed by equity (25% of the Net
Invested Capital, NIC) and long-term financial debt (75% of the NIC). The financial debt is
a bond with a maturity of 10 years, an annual interest rate of 3.5%, and monthly installments
with constant principal repayments. The initial financial leverage changes over the years
in the planning horizon (see Figure 2a), at the same time influencing the dynamic of Roe
(Figure 2b).
Invested Capital, NIC) and long-term financial debt (75% of the NIC). The financial debt
is a bond with a maturity of 10 years, an annual interest rate of 3.5%, and monthly
Risks 2021, 9, 105 installments with constant principal repayments. The initial financial leverage changes
15 of 36
over the years in the planning horizon (see Figure 2a), at the same time influencing the
dynamic of Roe (Figure 2b).
(a)
(b)
Figure2.2.Main
Figure Mainratios:
ratios:(a)
(a)—Financial leverage
Financial leverage changes.
changes. (b)(b)—Dynamic of Roe.
Dynamic of Roe.
For each
For each period,
period, the
the expected
expected value
value and
and thethe probabilistic
probabilistic variance
variance and andstandard
standard
deviation of
deviation of economic
economic results
results (see
(see Table
Table 6a)
6a) and
and financial
financial results
results (see
(see Table
Table 6b)
6b) were
were
calculated. The
calculated. The financing
financing policies
policiesaffect
affectboth
boththe thelevel
levelofofmandatory
mandatoryrepayments
repaymentson ondebt
debt
andtheir
and theircovariance withCFFs,
covariancewith CFFs,asaswell
wellas
asdebt
debtreserves.
reserves.
The firm valuation is run in each scenario through the DCF model assuming an asset-
Table 6. Expected results: (a)—Expectedand
side perspective earnings at endthe
adopting of year
APV1. procedure;
(b)—Expected thecash flows at end
unlevered costofofyear 1.
capital (ku) is
estimated using the CAPM with a risk-free rate of 2.0%, a market risk premium of 6.5%, and
(a)
an unlevered beta of 0.9. The expected value in a liquidation hypothesis, which represents
P/L (k/€)
a “floor” for the potential losses of creditors, was Forecasts
estimated considering a depreciation rate
Scenario 1
of fixed assets of 25% and a loss on expected 2
receivables …of 40%.15 E Sd
Probabilities 0.91% 1.82% … 0.91%
Company values (FV), share values (EqV), implicit multiples, and their variability (see
Revenues 1710.00
Table 7) do not consider default costs, 1728.00
which will … 1962.00
be introduced later. 1832.92 50.91
Variable costs −342.00 −345.60 … −392.40 −366.58 10.18
Fixed costs −1200.00 −1200.00 … −1200.00 −1200.00 0.00
Risks 2021, 9, 105 16 of 36
Table 6. Expected results: (a) Expected earnings at end of year 1. (b) Expected cash flows at end of year 1.
(a)
P/L (k/€) Forecasts
Scenario 1 2 ... 15 E Sd
Probabilities 0.91% 1.82% ... 0.91%
Revenues 1710.00 1728.00 ... 1962.00 1832.92 50.91
Variable costs −342.00 −345.60 ... −392.40 −366.58 10.18
Fixed costs −1200.00 −1200.00 ... −1200.00 −1200.00 0.00
EBITDA 168.00 182.40 ... 369.60 266.33 40.72
Depr. and Amort. −181.10 −181.10 ... −181.10 −181.10 0.00
EBIT −13.10 1.30 ... 188.50 85.23 40.72
Interest on Bonds −52.50 −52.50 ... −52.50 −52.50 0.00
Interest on Loans 0.00 0.00 ... 0.00 0.00 0.00
EBT −65.60 −51.20 ... 136.00 32.73 40.72
Taxes 0.00 0.00 ... −34.00 −8.18 8.53
NI −65.60 −51.20 ... 102.00 24.55 32.69
(b)
CASH FLOW STAT. (k/€) Forecasts
Scenario 1 2 ... 15 E Sd
Cash In Flow 1776.30 1791.84 ... 1993.86 1882.42 43.95
Cash Out Flow −1533.62 −1537.02 ... −1615.16 −1564.99 17.92
Operating Cash Flow (CFO) 242.68 254.82 ... 378.70 317.43 26.33
Cap.Ex. −181.10 −181.10 ... −181.10 −181.10 0.00
CASH FLOW to FIRM (CFF) 61.58 73.72 ... 197.60 136.33 26.33
Interest on Bonds −52.50 −52.50 ... −52.50 −52.50 0.00
Interest on Loans 0.00 0.00 ... 0.00 0.00 0.00
Repayments on Bonds −150.00 −150.00 ... −150.00 −150.00 0.00
Mandatory repayments on Loans (ARF) 0.00 0.00 ... 0.00 0.00 0.00
FINANCIAL SURPLUS/(NEEDS) −140.92 −128.78 ... −4.90 −66.17 26.33
Uses of ARF 0.00 0.00 ... 0.00 0.00 0.00
Uses of LoF 0.00 0.00 ... 0.00 0.00 0.00
FREE CASH FLOW to EQUITY (FCFE) −140.92 −128.78 ... −4.90 −66.17 26.33
Discretional repayments on Loans (ARF) 0.00 0.00 ... 0.00 0.00 0.00
Discretional repayments on Loans (LoC) 0.00 0.00 ... 0.00 0.00 0.00
Dividend pay-out 0.00 0.00 ... 0.00 0.00 0.00
NET CASH FLOW (NCF) −140.92 −128.78 ... −4.90 −66.17 26.33
Table 7. Expected economic and liquidation values.
FIRM VALUATION (t = 0; k/€) Scenario

Economic Values 1 2 ... 15 E Sd
Probabilities 0.91% 1.82% ... 0.91%
ECONOMIC ASSET VALUE 677.48 833.12 ... 2766.04 1698.36 419.35
CASH & CASH EQUIVALENT 0.00 0.00 ... 0.00 0.00 0.00
TAX SHIELD 291.98 291.98 ... 315.69 312.28 6.87
FVgc 969.46 1125.10 ... 3081.73 2010.64 424.37
FD −1500.00 −1500.00 ... −1500.00 −1500.00 0.00
EqVgc −530.54 −374.90 ... 1581.73 510.64 424.37
FV/CINactual 0.48 0.56 ... 1.54 1.01 0.21
EqV/NWactual −1.06 −0.75 ... 3.16 1.02 0.85
FVlc 1213.89 1227.05 ... 1364.70 1294.47 29.30
EqVlc −109.64 −96.48 ... 41.17 −29.06 29.30
FV/CINactual 0.61 0.61 ... 0.68 0.65 0.01
EqV/NWactual −0.22 −0.19 ... 0.08 −0.06 0.06
Risks 2021, 9, 105 17 of 36
Risks 2021, 9, xx FOR
FOR PEER
PEER REVIEW
REVIEW 17
17 of
of 36
Since
Since the
the expected
expected cash
cash flows
flows and economic values
and economic values are random variables
are random variables that move
variables that move
move
continuously, it is assumed that:
continuously, it is assumed that:
-- the
the expected
the expected value
expected value and
value and the
and the standard
the standard deviation
standard deviation are
deviation are representative
are representative of
representative of the
of the entire
the entire distri-
entire distri-
distri-
bution
bution of
of flows
flows and values;
bution of flows and values; and and
--- these
these distributions
these distributions are
distributions are continuous,
are continuous, normal,
continuous, normal, and
normal, and symmetrical
symmetrical consistently
consistently with
with the
the
assumption
assumption on
on the
the revenue’s distribution.
assumption on the revenue’s distribution.
The VaR
The VaR logic
VaRlogic allows
allows
logic us tous
allows to
to measure
measure
us the areas
measure the areas
areas ofof insolvency
of insolvency
the underlying
underlying the
insolvency the
distributions
underlying the
distributions
of firm of
values, firm
thus values,
defining thus
the defining
probability the
of probability
default in a of default
going in
concern a going concern
hypothesis
distributions of firm values, thus defining the probability of default in a going concern (see
hypothesis (see
(seeofFigure
Figure 3), and
hypothesis 3),
3), and
bankruptcy
Figure andinof
ofa bankruptcy in
in aa liquidation
liquidation hypothesis
bankruptcy hypothesis
(see Figure
liquidation 4). (see
hypothesis (see Figure
Figure 4).
4).
Figure
Figure 3. Probabilistic
3. Probabilistic
Figure 3. distributions
Probabilistic distributions of FV
FVgc and
of FV
distributions of
gc
gc and areas
and areas of
areas of default
of default risk.
default risk.
risk.
Figure 4.
4. Probabilistic distributions
Probabilistic distributions of
distributions of FV
FVlclc and
of FV
lc
and areas of bankruptcy
bankruptcy risk.
Figure and areas
areas of
of bankruptcy risk.
risk.
The
The risk-based
risk-based measures
measures relevant
relevant to
to the
the treatment
treatment of of insolvency
insolvency risk
risk were
were estimated
estimated
both in a going
both in a going concern
going concern hypothesis
concern hypothesis and
hypothesis and
and inin a liquidation
in aa liquidation concern
liquidation concern hypothesis:
concern hypothesis: Capital
hypothesis: Capital at at
α α
Risk (CaR α) applying Equations (7) or (10), Equity Risk Capital (ERC α α) applying [8] or [11],
Risk (CaR ) applying Equations (7) or (10), Equity Risk Capital (ERC ) applying [8] or [11],
α
and Equity Risk
and Equity Risk Capital
Risk Capital Needs/Surplus
Needs/Surplus (ERC
Capital Needs/Surplus (ERCn/s n/s)) )applying
n/s
applyingEquations
applying Equations(9)
Equations (9) or
(9) or (12).
or (12). All the
the
All the
measures were determined considering a holding period of 1 year and
measures were determined considering a holding period of 1 year and a confidence level a confidence level
of
of 95%
95% oror 99%
99% (Table
(Table 8).
(Table 8).
8).
Moving to the short-term analysis, the simulation model allows us to estimate the
probability that a situation of financial distress will occur, and to measure the risk capital
needed to deal with such a situation. Analyzing the variability in monthly CFF and FSN, it
emerges that the probabilities of a shortfall in cash and financial distress vary throughout
the year because of the variability and seasonality of the expected revenues. For example,
Risks 2021, 9, x FOR PEER REVIEW 18 of 36
Risks 2021, 9, 105 18 of 36

Table 8. Risk-based measures for default and bankruptcy risk.
Confidence Level Confidence Level
Expected Value E SD 95.00% CaR in
the shortfall in cash risk and financial distress risk are higher 99.00%
March (see FigureCaR5a) than
FVgc 2010.64 424.37 1312.62 698.02 1023.42 987.23
in May (see Figure 5b).
FVlc 1294.47 29.30 1246.27 48.20 1226.31 68.17
Expected Value Threshold ERC ARC RCn/s ARC RCn/s
FVRisk-based
Table 8. gc measures
1500.00for default and bankruptcy
687.38 500.00 risk.
−187.38 500.00 −476.58
FV lc 1323.53 577.25 500.00 −77.25 500.00 −97.22
Confidence Level Confidence Level
Expectedto
Moving Value E analysis,
the short-term SDthe simulation
95.00% model CaRallows 99.00%
us to estimateCaRthe
probabilityFV gc a situation
that of financial424.37
2010.64 distress will occur, and
1312.62 to measure
698.02 the risk capital
1023.42 987.23
FVlc with such1294.47
needed to deal 29.30
a situation. Analyzing 1246.27 48.20
the variability 1226.31
in monthly CFF and68.17
FSN,
it emerges
Expectedthat the probabilities
Value Threshold of ERC a shortfallARCin cash RCandn/s financial
ARCdistressRC vary
n/s
throughout thegc year because of the variability and seasonality of the expected revenues.
FV 1500.00 687.38 500.00 −187.38 500.00 −476.58
For example,
FVlcthe shortfall1323.53
in cash risk577.25
and financial distress−risk
500.00 77.25are higher
500.00in March (see
−97.22
Figure 5a) than in May (see Figure 5b).
(a)
(b)
Figure distributions
5. Probabilistic of CFF
distributions andand
of CFF FSN: (a)—
FSN: (a)March.
March.(b)— May.
(b) May.
TheThemonthly
monthly CFFand
CFF FSNwere
andFSN were calculated byapplying
calculated by applyingEquations
Equations (16)
(16) andand
(17),(17),
while
while CFaR
the the was was
CFaR calculated by applying
calculated Equation
by applying (1) in two
Equation different
(1) in hypotheses
two different of confidence
hypotheses of
confidence level (see Figure 6a) along with the related probabilities of financial distress6b).
level (see Figure 6a) along with the related probabilities of financial distress (see Figure
(see Figure 6b).
Risks 2021, 9, 105 19 of 36
(a)
(b)
Figure 6.
Figure 6. Monthly
Monthly cash
cash flows
flows and
and risks:
risks: (a)
(a)—Expected cash
Expected cash flows.
flows. (b)(b)—Distress probabilities.
Distress probabilities.
In other
In otherterms,
terms,thethefirm’s
firm’sfinancing
financing policy
policy is not
is not coherent
coherent withwith
the the seasonality
seasonality and and
the
the variability of revenues, leading to a situation of financial distress at the
variability of revenues, leading to a situation of financial distress at the beginning of the beginning of
the second
second quarterquarter
of theofyear.
the The
year. The risk-based
risk-based measures measures
relevantrelevant to the treatment
to the treatment of
of liquidity
liquidity
risk wereriskthenwere then determined
determined considering considering
a holdinga holding
period ofperiod of 1 month,
1 month, a confidence
a confidence level
level
of 95% of or
95% or 99%,
99%, the Liquidity
the Liquidity RiskRisk Capital
Capital (LRC α) α
(LRC ) applying
applying Equation(3),
Equation (3),the
theAvailable
Available
Liquidity Risk
Liquidity Risk Capital
Capital (LRC av
(LRCav) applying Equation (4) (see Figure Figure 7b),
7b), the
the Liquidity
Liquidity Risk
Risk
Capital Needs/Surplus (LRCn/s
Capital Needs/Surplus n/s)) applying
applying Equation
Equation (5), and the Resilience
Resilience Index
Index applying
applying
Equation
Equation (6) (6) (see
(see Figure
Figure 7a).
7a).
Risks 2021, 9, 105 20 of 36
(a)
(b)
Figure 7.
Figure 7. Liquidity
Liquidity Risk
Risk Capital:
Capital: (a)
(a)—Risk Capital
Risk Capital Surplus/Needsand
Surplus/Needs andResilience
ResilienceIndex.
Index.(b)
(b)—Opti-
Optimal
mal and Available Liquidity Risk Capital.
and Available Liquidity Risk Capital.
4.3. Simulations
While the probability
While probability of
of default
default is relatively
relatively low,
low, the
the scenario
scenario analysis
analysis shows
shows that
that the
the
capital structure of the firm should be modified to avoid a condition of financial distress.
This can
This can be obtained through several actions, keeping unchanged the net invested capital.
Those considered
Those considered in
in the
the simulation
simulation are
are (Table
(Table9):
9):
- a reduction
reduction in
infinancial
financialdebt
debtoffset
offsetbybya acorrespondent
correspondent increase in in
increase equity (first
equity strategy,
(first strat-
S1);
egy, S1);
- a reduction in net financial debt due
due toto an
an increase
increase in
in liquidity
liquidity obtained
obtained through
through an an
equivalent increase in equity (second strategy, S2); and
strategy, S2); and
- an increase in short-term
short-term debt
debt keeping
keeping unchanged
unchanged thethe overall
overall financial
financial debt,
debt, with
with
creation of debt reserves (third strategy,S3).
(third strategy, S3).
Risks 2021, 9, 105 21 of 36
Table 9. Alternative financing strategies and financial leverages.

Table 9. Alternative financing strategies and financial leverages.
Capital Structure
Financing Financial Leverage
Capital Structure
Strategies
Financing H1 H2 Financial Leverage
H3 H4
Strategies 75.00% H1 70.00% H2 65.00%H3 60.00%H4 FD/NIC
0.00% 0.00% 0.00% 0.00% FD st/FD
S1 75.00% 70.00% 65.00% 60.00% FD/NIC
0.00% 0.00% 0.00% 0.00% 0.00%0.00% 0.00%
0.00% DR/NIC
FD st/FD
S1 0.00% 0.00% 0.00% 0.00% 0.00% C&CE/NIC
0.00% 0.00% 0.00% DR/NIC
75.00% 0.00% 75.00% 0.00% 75.00%0.00% 0.00%
75.00% C&CE/NIC
FD/NIC
0.00% 75.00% 0.00%75.00% 0.00% 75.00% 0.00%
75.00% FD FD/NIC
st/FD
S2 0.00% FD st/FD
S2 0.00% 0.00% 0.00% 0.00%0.00% 0.00%
0.00% DR/NIC
0.00% 0.00% 0.00% 0.00% DR/NIC
0.00% 5.00% 10.00% 15.00% C&CE/NIC
0.00% 5.00% 10.00% 15.00% C&CE/NIC
75.00% 75.00% 75.00% 75.00% FD/NIC
75.00% 75.00% 75.00% 75.00% FD/NIC
0.00% 0.00%
6.67% 6.67% 13.33% 13.33%
20.00%
20.00%
FDFD
st/FD
st/FD
S3 S3 0.00% 0.00% 2.50% 2.50% 2.50%2.50% 2.50%
2.50% DR/NIC
DR/NIC
0.00% 0.00% 0.00% 0.00% 0.00%0.00% 0.00%
0.00% C&CE/NIC
C&CE/NIC
4.3.1. FirstFirst
4.3.1. Financing
FinancingStrategy
Strategy(S1)(S1)
TheThe
firstfirst
simulation
simulation considers
considersthree different
three hypotheses
different hypotheses of capital structure,
of capital which
structure, which
are are
alternatives
alternatives to to
thethe
initial one.
initial one.AAreduction
reductionininfinancial
financialleverage
leverage involves (see(see Figure
Figure8a):
8a):thethetransition
transitionfromfrom a lack
a lack of equity
of equity to ato a high
high surplus
surplus (see Figure
(see Figure 8b); a significant
8b); a significant reduction
reduction
in the probabilities of default and bankruptcy (see Figure 8c); and a slight reduction inre-
in the probabilities of default and bankruptcy (see Figure 8c); and a slight both
duction in both
asset-side andasset-side
equity-side andmultiples
equity-side multiples
(see Figure 8d).(see Figure 8d).
A financial
A financial strategy
strategy exclusively
exclusivelybased
basedononaa reduction in infinancial
financialdebt,
debt,ononthethe
oneone
hand,
hand, reduces
reduces the probability
the probability of default
of default and eliminates
and eliminates that ofthat of bankruptcy,
bankruptcy, but,other
but, on the on the
hand,
other hand, itainvolves
it involves significanta reduction
significantinreduction in value
value creation creation
for the for the Furthermore,
shareholders. shareholders.this
financial strategy
Furthermore, is not strategy
this financial effectiveisinnot
reducing theinrisk
effective of financial
reducing distress
the risk (see Figure
of financial 9a,c);
distress
(see Figure 9a,c); in fact, the need for liquidity risk capital (see Figure 9b) is reduced verythe
in fact, the need for liquidity risk capital (see Figure 9b) is reduced very little and
certainty
little and the of the financial
certainty of thedistress
financial indistress
February in remains
February(see Figure(see
remains 9d).Figure 9d).
(a)
Figure 8. Cont.
Risks 2021, 9, 105 22 of 36
(b)
(c)
(d)
Figure 8. First
Figure simulation:
8. First dynamics
simulation: of capital
dynamics structure,
of capital risk and
structure, value:
risk and (a)—Debt/equity ratio. ratio.
value: (a) Debt/equity
(b)—Equity risk capital. (c)—Insolvency risk. (d)—Value creation.
(b) Equity risk capital. (c) Insolvency risk. (d) Value creation.
4.3.2. Second
4.3.2. Financing
Second Strategy
Financing (S2)(S2)
Strategy
TheThe
second
secondsimulation
simulation considers
considersa progressive
a progressivereduction of net
reduction financial
of net leverage,
financial leverage,
obtained
obtainednotnot
through
througha financial
a financialdebt
debtreduction,
reduction,but
butan
anincrease
increase in cash
cash and
andcash
cashequivalents
equiva-
lents corresponding
corresponding to increase
to an an increase in equity
in equity (see (see Figure
Figure 10a).10a).
This This strategy
strategy has similar
has similar impacts
impacts on risk capital (see Figure 10b), probabilities of default or bankruptcy (see Figure
10c), and value creation (see Figure 10d).
Risks 2021, 9, 105 23 of 36
21, 9, x FOR PEER REVIEW on risk capital (see Figure 10b), probabilities of default or bankruptcy25(see Figure 10c), and
of 39
value creation (see Figure 10d).
A condition of financial distress in the first year will be avoided in this case (see
Figure 11d) thanks to the increase in liquidity (see Figure 11b). This strategy has no effect
on the optimal level of risk capital (see Figure 11a), nor on the shortfall in cash risk (see
little and the certainty of the financial distress in February remains (see Figure 9d).
Figure 11c).
(a)
(b)
(c)
Figure 9. Cont.
Risks 2021, 9, 105 24 of 36
(d)
(d)
Figure 9. First simulation: dynamics of Liquidity Risk Capital: (a)—Optimal liquidity risk-capital.
Figure
Figure 9. First
9. First simulation:
simulation: dynamics
dynamics of of Liquidity
Liquidity Risk Risk Capital: (a) Optimal
Capital: liquidity risk-capital.
(b)—Available liquidity risk-capital. (c)—Shortfall in cash risk.(a)—Optimal
(d)—Distressliquidity risk-capital.
probability.
(b) Available liquidity risk-capital. (c) Shortfall in cash risk. (d) Distress probability.
(b)—Available liquidity risk-capital. (c)—Shortfall in cash risk. (d)—Distress probability.
(a)
(a)
(b)
(b)
Figure 10. Cont.

Risks 2021, 9, 105 25 of 36

(c)
(c)
(d)
Figure 10. Second simulation: dynamics of capital structure, risk and value: (a)—Debt/equity ratio.
(d)
Figure 11d) thanks to the increase in liquidity (see Figure
Figure 10. Second simulation: dynamics of capital structure, risk11b). This strategy
and value: has no effect
(a)—Debt/equity ratio.
Figure 10. Second
on the optimal simulation:
level of dynamics
risk capital (see of capital structure, risk and value: (a) Debt/equity ratio.
(b)—Equity risk capital. (c)—Insolvency risk.Figure 11a),creation.
(d)—Value nor on the shortfall in cash risk (see
(b) Equity
Figure 11c). risk capital. (c) Insolvency risk. (d) Value creation.
Figure 11d) thanks to the increase in liquidity (see Figure 11b). This strategy has no effect
on the optimal level of risk capital (see Figure 11a), nor on the shortfall in cash risk (see
Figure 11c).
(a)
Figure 11. Cont.
(a)
Risks 2021, 9, 105 26 of 36
(b)
(c)
(d)
Figure
Figure11.11.
Second simulation:
Second dynamics
simulation: dynamics ofof
Liquidity
LiquidityRisk
RiskCapital:
Capital:(a)—Optimal
(a) Optimal liquidity risk-
liquidity risk-capital.
capital. (b)—Available liquidity risk-capital. (c)—Shortfall in cash risk. (d)—Distress probability.
4.3.3. Third
4.3.3. Financing
Third Financing Strategy
Strategy (S3)
(S3)
TheThethird
thirdsimulation considersaagradual
simulation considers gradual increase
increase in short-term
in short-term debt,debt,
whilewhile the
the overall
overall debt remains
debt remains flat
flat (see (see Figure
Figure 12a).
12a). The The short-term
short-term debt consists
debt consists of: aline
of: a credit credit
forline for
advance
advance invoices that increases up to a maximum of 150 k/€ with an annual interest
invoices that increases up to a maximum of 150 k/€ with an annual interest rate of 6%; and rate
ofan
6%; and an line
ordinary ordinary linethat
of credit of credit that up
increases increases
to 150 up
k/€towith
150 an
k/€annual
with an annualrate
interest interest
of 6%.
rate of 6%. Compared with the previous simulations and hypotheses, this strategy allows
Risks 2021, 9, 105 27 of 36
Compared with the previous simulations and hypotheses, this strategy allows us to limit
usrisk of default
to limit risk of(see Figure
default 12c)
(see and to
Figure increase
12c) and tothe value the
increase creation
value(see Figure(see
creation 12d), but it
Figure
does not reduce the risks of bankruptcy and the lack of ERC in a liquidation scenario
12d), but it does not reduce the risks of bankruptcy and the lack of ERC in a liquidation (see
Figure 12b).
scenario (see Figure 12b).
(a)
(b)
(c)
Figure 12. Cont.

Risks 2021, 9, 105 28 of 36
(d)
(d)
Figure
Figure
Figure 12.12.
12. Third
Third simulation:
Third simulation:
simulation: dynamics ofofcapital
dynamics
dynamics capital structure,
of capital riskand
structure,
structure, risk and value:
riskvalue: (a)—Short-term
and value: debt.debt.
(a) Short-term
(a)—Short-term debt.
(b)—Equity
(b) Equityrisk
riskcapital.
capital.(c)—Insolvency risk.(d)
(c) Insolvency risk. (d)—Value creation.
Value creation.
InInInthis
this case,
this
case, aacondition
case, condition
a conditionoffinancial
of financial distress
of financial willoccur
distress
distress will occuroccur
will withcertainty
with certainty
with during
certainty
during thefirst
during
the first
the
year
year (see
first(see Figure
yearFigure 13c,d);
(see Figure indeed,
13c,d);13c,d); this
indeed,
indeed, financing strategy
this financing
this financing has
strategy
strategy no
has has relevant effects
no relevant
no relevant on
effects
effects on on the
thethe
reduction
reduction
reduction ofof
of liquidity
liquidity
liquidity risk-capital
risk-capital
risk-capital needs.
needs.
needs.
(a)
(a)
(b)
(b)
Figure 13. Cont.

Risks 2021, 9, 105 29 of 36
(c)
(d)
Figure 13.13.
Figure Third simulation:
Third dynamics
simulation: dynamics of Liquidity Risk
of Liquidity Capital:
Risk (a)—Optimal
Capital: (a) Optimalliquidity risk-capi-
liquidity risk-capital.
tal. (b)—Available liquidity risk-capital. (c)—Shortfall in cash risk. (d)—Distress probability.
5. 5.
Discussion of of
Discussion Results
Results
TheThecomparison
comparison of of
thethe different
different financial
financial strategies
strategies clearly
clearly shows
shows that,
that,given
giventhethe
business
businessconditions
conditions assumed
assumed above,above,changes
changesin in thethe financial
financial structure
structure allowallow us to
us to optimize
optimize the liquidity
the liquidity or equityorrisk-capital,
equity risk-capital,
reducing reducing
the insolvencythe insolvency
risk. However, risk. adjustments
However,
adjustments in equity allow
in equity risk-capital risk-capital allow us to reduce/eliminate
us to reduce/eliminate the probability ofthe probability of
default/bankruptcy,
but do not allow usbut
default/bankruptcy, to reduce
do not the allowprobability
us to reduceof financial distress, which
the probability instead
of financial requires
distress,
adjustments
which in liquidity
instead requires risk-capital.
adjustments in liquidity risk-capital.
TheThe financial
financial strategy
strategy S1S1 produces
produces a significant
a significant reduction
reduction in the
in the default
default probability,
probability,
butbut
nono reduction
reduction in in
thethe distress
distress probability.
probability. Thanks
Thanks toto a net
a net financial
financial leverage
leverage (NFD/NW)
(NFD/NW)
reduction
reduction fromfrom 3.00
3.00 to to 1.50
1.50 (−50.50%),
(−50.50%), thethe probability
probability of of default
default reduces
reduces from
from 11.44%
11.44% to to
4.16%
4.16% (−63.64%),
(−63.64%), andand thethe probability
probability of of bankruptcy
bankruptcy reduces
reduces fromfrom 83%83% to to
0%0% (−100%).
(−100%).
However,
However, thisdoes
this doesnot noteliminate
eliminatethe thecondition
condition of of distress
distress that occursoccurs in in the
thefirst
firstyear
yearofofthe
plan (in February, a distress probability of 100%). The financial
the plan (in February, a distress probability of 100%). The financial strategy S2 produces strategy S2 produces similar
effectseffects
similar on theon default risk, but
the default it significantly
risk, reducesreduces
but it significantly the first-year distress distress
the first-year risk. When risk.the
reduction
When in net financial
the reduction in netleverage
financialis leverage
obtained is by obtained
an increase byinan theincrease
firm’s liquidity, the risk
in the firm’s
of financial
liquidity, distress
the risk in the first
of financial year ofinthe
distress thebudget is eliminated.
first year of the budget The isfinancial TheS3
strategy
eliminated.
does not produce significant effects either on the default risk nor
financial strategy S3 does not produce significant effects either on the default risk nor on on the distress risk. The
the distress risk. The greater flexibility of the financial structure together with debt to
greater flexibility of the financial structure together with debt reserves are not sufficient
reduceare
reserves thenot overall insolvency
sufficient risk.the overall insolvency risk.
to reduce
Moreover, if there is seasonality, the financial structure assessment and optimization
always require combining a short-term analysis with a medium to long term one. Notice
Risks 2021, 9, 105 30 of 36
Moreover, if there is seasonality, the financial structure assessment and optimization al-
Risks 2021, 9, x FOR PEER REVIEW ways require combining a short-term analysis with a medium to long term one. Notice 30 of that
36
the distress probability on an annual basis differs from those calculated on a monthly basis.
The effects of the three financial strategies can be also observed through the dynamics
of LRC and ERC. Their needs or surplus make it possible to optimize the firm’s capital
that the distress
structure probability
and avoid excessive on an or annual basischanges
insufficient differs from those calculated
in leverage with respecton atomonthly
a specific
basis.
risk target. The simulation’s results show that any surplus of equity risk-capital does not
The effects
generate of the reductive
significant three financialeffectsstrategies can bewhile
on firm value, also observed through
it generates the dynamics
significant effects on
ofequity
LRC and ERC. Their needs or surplus make it possible to optimize
value. When the direct and indirect insolvency costs are nil (as per the hypothesis the firm’s capital
structure and avoid excessive or insufficient changes in leverage
underlying the previous simulations), the excessive equity risk generates reductions in with respect to a specific
risk target.
equity The simulation’s
value. Furthermore,results show that
the balance any surplus
between insolvencyof equity risk-capital
risk and economic does notis
value
generate
obtained significant
by combining reductive
several effects on firm
financial value,to
strategies while
avoidit excessively
generates significant
reducing debt effects
and
onlosing
equity value. When
the related tax benefits. the direct and indirect insolvency costs are nil (as per the
hypothesis
Comparingunderlying thefinancial
the three previousstrategies
simulations),
is useful thetoexcessive equity risk between
highlight correlations generates the
reductions in equity value. Furthermore, the balance between
probability of distress or default, a surplus/an excess in liquidity or equity risk capital, insolvency risk and and
economic
the creation value ofisfirm
obtained
value by andcombining several
equity value. We financial
considered strategies to avoid
an increasing costexcessively
of default:
reducing debt andoflosing
four incidences distressthecosts
related tax economic
on the benefits. value (zero, 0%; low, 10%; medium, 15%;
high,Comparing
20%) and the fourthree financial
incidences strategies iscosts
of bankruptcy usefulon to
thehighlight
liquidationcorrelations
value (zero, between
0%; low,
the probability
3 %; medium,of 4%;distress
high, or 5%) default, a surplus/an excess in liquidity or equity risk capital,
are assumed.
and the For creation of firm value
each hypothesis and equity
of default value.
costs, the We considered
economic an increasing
value, liquidation value, and cost firm
of
default:
value were four calculated
incidencesbyofapplying
distress Equations
costs on the economic
(13–15), value (zero, 0%; low, 10%;
respectively.
medium, 15%;
If the high,of20%)
costs and have
default four incidences
a relevantof(medium
bankruptcy costs on
or high) the liquidation
incidence, value
the multiples
implicit
(zero, 0%;in low,the3firm value (see4%;
%; medium, Figure
high,14a)
5%)andareequity
assumed.value (see Figure 14b) tend to decrease
significantly as the probability
For each hypothesis of default of default increases.
costs, the economic value, liquidation value, and firm
A similar
value were behavior
calculated was observed
by applying considering
Equations (13–15), therespectively.
distress probability estimated in the
firstIfyear of the plan; the reduction effects
the costs of default have a relevant (medium or high)are significant bothincidence,
on asset-side
the (see Figureim-
multiples 15a)
and equity-side (see Figure 15b) multiples due to the higher
plicit in the firm value (see Figure 14a) and equity value (see Figure 14b) tend to decrease incidence of restructuring
costs compared
significantly as thewith bankruptcy
probability costs. increases.
of default
AIn other behavior
similar words, the wasinsolvency costs reducethe
observed considering thedistress
firm value consistently
probability estimatedwith inthe
trade-off
the first yeartheory
of the on thethe
plan; one hand, and
reduction on are
effects the significant
other eliminateboth ontheasset-side
advantage (seefor share-
Figure
holders
15a) and deriving
equity-side from(seethe asymmetry
Figure 15b)of multiples
the firm’s payoffs,
due to consistently
the higher with the option
incidence of
pricing model.
restructuring costs compared with bankruptcy costs.
(a)
Figure 14. Cont.

Risks 2021, 9, 105 31 of 36
(b)
(b)
Figure 14. Multiples and probability of default: (a)—Asset multiples. (b)—Equity multiples.
Figure14.
Figure Multiplesand
14.Multiples andprobability
probabilityofofdefault:
default:(a)—Asset
(a) Asset multiples.
multiples.(b) Equity multiples.
(b)—Equity multiples.
(a)
(a)
(b)
(b)
Figure 15. Multiples and probability of distress: (a)—Asset multiples. (b)—Equity multiples.
Figure 15. Multiples and probability of distress: (a)—Asset multiples. (b)—Equity multiples.
Figure 15. Multiples and probability of distress: (a) Asset multiples. (b) Equity multiples.
In other words, the insolvency costs reduce the firm value consistently with the trade-
In other
off theory words,
on the one the insolvency
hand, and on costs reduce
the other the firmthe
eliminate value consistently
advantage with the trade-
for shareholders
off theory on the one hand, and on the other eliminate the advantage for shareholders
Risks 2021, 9, 105 32 of 36
deriving from the asymmetry of the firm’s payoffs, consistently with the option pricing
model.
Thesimulation
The simulationmodel
modelalso
alsoallows
allowsusustotodepict
depictthe
thedynamics
dynamicsofoffirm
firmvalue
valueand
andequity
equity
value compared to the risk-capital excess or deficit. Moving from a situation
value compared to the risk-capital excess or deficit. Moving from a situation of an ERC of an ERC
deficit to a surplus one, the value creation increases, both on the asset side (see Figure
deficit to a surplus one, the value creation increases, both on the asset side (see Figure 16a) 16a)
and the equity side (see Figure 16b), only if the default costs are significant.
and the equity side (see Figure 16b), only if the default costs are significant.
(a)
(b)
Figure
Figure16.
16.Multiples and
Multiples Equity
and Risk
Equity Capital:
Risk (a)—Asset
Capital: multiples
(a) Asset andand
multiples Equity RiskRisk
Equity Capital sur- sur-
Capital
plus/needs. (b)—Equity multiples and Equity Risk Capital surplus/needs.
plus/needs. (b) Equity multiples and Equity Risk Capital surplus/needs.
Without
Withoutinsolvency
insolvencycosts,
costs,surpluses
surplusesor orneeds
needsofof equity
equity capital
capital have
have almost
almost zero
zero
effects
effects on firm value and equity value. The ERC is therefore useful to detect excessive
on firm value and equity value. The ERC is therefore useful to detect excessive
default
defaultrisk
riskhedging,
hedging,incoherent
incoherentwith
withthe
theprinciple
principleof ofshareholder
shareholdervaluevaluecreation.
creation.When
When
insolvency
insolvencycostscosts become
become relevant, an an excess
excessofofequity
equitycapital
capitalbenefits
benefits the
the value
value creation
creation for
for shareholders
shareholders andand lenders.
lenders. Similar
Similar considerations
considerations applyapply to correlation
to the the correlation between
between asset
asset multiples
multiples (see (see Figure
Figure 17a)17a) or equity
or equity multiples
multiples (see(see Figure
Figure 17b)17b)
andand deficits/excesses
deficits/excesses of
ofliquidity
liquidityrisk-capital.
risk-capital.
Therefore, risk-capital measures are useful in defining financial policies aimed at re-
ducing the insolvency risk consistently with the principle of corporate value maximization.
When insolvency costs are null, excesses of equity or liquidity generate negative effects on
firm value. This is due to an excess of assets less profitable than the operating ones and
a financial debt not sufficient to fully obtain the potential tax benefits. When insolvency
costs become relevant, an excess of equity or liquidity might help to create value for all
investors (shareholders and lenders) depending on the magnitude of those costs.
Risks 2021, 9, 105 33 of 36
(a)
(b)
Figure
Figure17.
17.Multiples
Multiplesand Liquidity
and Risk
Liquidity Capital:
Risk (a)—Asset
Capital: multiples
(a) Asset andand
multiples Liquidity RiskRisk
Liquidity Capital
Capital
surplus/needs. (b)—Equity multiples and Liquidity Risk Capital surplus/needs.
surplus/needs. (b) Equity multiples and Liquidity Risk Capital surplus/needs.
Therefore, risk-capital measures are useful in defining financial policies aimed at

6. Conclusions
reducing This the
paperinsolvency
aims to: risk consistently with the principle of corporate value
maximization. When insolvency costs are null, excesses of equity or liquidity generate
(1) define and quantify risk-based capital measures to counter the insolvency risk in
negative effects on firm value. This is due to an excess of assets less profitable than the
operating ones and
(2) investigate a financialondebt
conditions andnot sufficient
limits to theirtouse
fully
in obtain thestrategies.
financing potential tax benefits.
When insolvency costs become relevant, an excess of equity or liquidity might help to
(1). Two risk-capital measures were proposed. Equity risk-capital us allows to check
create value for all investors (shareholders and lenders) depending on the magnitude of
whether the financial structure presents a net worth sufficient to ensure the “medium
those costs.
to long term solvency” of the firm; liquidity risk-capital allows us to check whether
the firm has sufficient liquidity to balance cash in and cash out, ensuring “short-term
6. Conclusions
solvency”. These risk capital measures depend on the operating cash flow variability—due
This paper strategies
to competitive aims to: and operating policies—and on capital structure—determined by
(1).
the define and quantify
firm financing risk-based
policies. Corporatecapital measures
policies to counter
determine the insolvency
the asset risk in of a
and cost structure
firm and, therefore, the way in which the uncertainty of turnover becomes the variability in
(2). investigate
its operating conditions
results; on and
financing limitsdetermine
policies to their use
theinfirm’s
financing
abilitystrategies.
to cover financial needs.
Consequently, the nature of the firm (manufacturing,
(1). Two risk-capital measures were proposed. Equity risk-capitalcommercial, service company),
us allows the
to check
industry to which it belongs, and the investments done (development
whether the financial structure presents a net worth sufficient to ensure the “medium to or maintenance)
affect
long termboth the LRC of
solvency” and theERC.
firm; liquidity risk-capital allows us to check whether the firm
has sufficient liquidity to balance cash in and cash out, ensuring “short-term solvency”.
Risks 2021, 9, 105 34 of 36
These measures are based on the VaR logic and require a simulation approach to
financial planning and budgeting. The simulation model allows us to explicitly consider
the variability in the expected returns in financial plans and budgets. Although advanced
tools and models for data analysis and forecasting have been developed thanks to tech-
nological and digital innovation, their use by CFOs remains relatively limited, especially
in SMEs. Both of the proposed measures depend on several choices that management
should make to apply the VaR logic and to set up forecasting procedures for planning
and budgeting. These choices have a relevant impact on the estimation of the proposed
risk-capital measures, which are strictly dependent on the management approach to risk
assessment and forecasting.
(2). The simulation model allows us to check whether a firm’s financial policies, based
on a reduction in LRC or ERC needs/surplus and aimed at reducing the insolvency risk,
are consistent with the principle of corporate value maximization. The main results from
the simulation model are as follows.
A corporate capital structure optimization based on LRC and ERC gives benefits in
terms of value maximization. When the insolvency costs are relevant, consistently with
the trade-off theory, ERC and LRC are useful to balance the advantages (tax benefits) and
disadvantages (direct and indirect costs of bankruptcy) of a financial policy.
Practical implications in the entrepreneurial and managerial field are evident.
A firm should consider LRC or ERC as “theoretical” or “regulatory” measures useful to
implement capital structures (assets and liabilities) able to maintain conditions of financial
equilibrium in the short and medium to long term. Therefore, the proposed risk-capital
measures are useful to compose a decision-making model for corporate financial policies
that integrates the goals of value maximization and equilibrium maintenance and allows
for a continuous assessment of the trade-off between insolvency risk and firm value.
LRC allows for an assessment of the debt reserves and, therefore, of the effective
financial flexibility of the firm. Debt reserves built with lines of credit linked to operations’
volume or turnover do not always allow for the elimination of the risk of financial distress.
This is because they may be not available or may generate mandatory repayments that
increase the lack of liquidity.
Since the costs of financial default are normally significant, both direct (restructuring
procedures) and indirect (loss of market and margins), LRC and ERC appear useful in
preventing and facing corporate financial crises, allowing for an assessment of default
probability and financial buffers. These measures make it possible to compose growth or
turnaround strategies based on the full sustainability, within a certain level of confidence,
of future financial policies.
Although LRC and ERC are effective measures for quantifying the capital buffers
necessary to counter insolvency risk, this paper presents just the first step of the search for
a full convergence between risk management and financial management. The main limits
of the results discussed above relate to the approach in defining the main parameters of the
simulation model (growth rate, variable costs, interest rates, etc.). This approach does not
incorporate into the simulation processes the (limited) ability of companies to adapt their
financial strategies and policies to the competitive pressures and dynamics of the context.
Nevertheless, to have a more comprehensive analysis and to provide more confidence in
the simulation’s results, future research will include: considering alternative probability
distributions (beta, log-normal, etc.) for turnover and the interest rate; designing an
effective methodology to perform an empirical check of LRC and ERC, first through case
studies and then though an econometric analysis; and verifying whether the use of LRC
and ERC in financial strategies allows us to improve the risk profile perceived by financial
investors and intermediaries.
Funding: This research received no external funding.

Institutional Review Board Statement: Not applicable.
Informed Consent Statement: Not applicable.
Risks 2021, 9, 105 35 of 36
Data Availability Statement: Not applicable.

Conflicts of Interest: The authors declare no conflict of interest.
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Citation: Gennaro, Alessandro. 2021.

Risks 2021, 9, 105. https://doi.org/10.3390/risks9060105 https://www.mdpi.com/journal/risks

2. Literature Review and Theoretical Framework

an estimation of the default probability, related costs, and methods to be considered in

3.1. Definition of Insolvency, Distress, and Default

3.2. Optimal Capital Structure

3.3. Risk-Based Capital Measures

CFaRαt = E(CFFt ) − Eα (CFFt ) (1)

LRCtα = CFDt − Eα (CFFt ) (2)

LRCtα = − Eα ( FSNt ) (3)

LRCtα = f ( EFSNt ; SDFSNt ; α)

VAR FSNt = VAR Ebitda∗t − VAR∆nwct − VARcapext − VARmrt

Definitely, LRC depends on:

Table 1. Liquidity Risk Capital and implicit probability of financial distress.

Risk Capital Probability of Financial Distress

ERCtα = f ( ECFFt ; SDCFFt ; α; wacc;)

CFFt = Ebitdat − Taxest − ∆nwct − Capext

Table 2. Equity Risk Capital and implicit probability of default.

Risk Capital in a Going Concern Probability of Default

Given a certain likelihood of business interruption, the firm’s solvency in a liquidation

Once again, ERCs/n implicitly provides information on the probability of bankruptcy

Table 3. Equity Risk Capital and implicit probability of bankruptcy.

Risk Capital in a Liquidation Concern Probability of Bankruptcy

In order for risk-based capital measures to be useful in setting up decision-making

cash flows in a limited number of scenarios (normally the triad “pessimistic–expected–

3.4. Firm Value and Insolvency Risk

In a liquidation hypothesis, the bankruptcy (direct) costs, whose incidence on firm

4. Scenario Analysis and Simulations: Methodology and Results

CFFt = Ebitda∗t − ∆nwct − Capext (16)

FSNt = Ebitda∗t − ∆nwct − Capext − Mrt (17)

VAR Ebitda∗t = [SDRevt ·(1 − v )·(1 − τ )]2 (19)

4.1. Parameter Values

The forecasting model

Table 5. Seasonality of annual revenues.

Table 7. Expected economic and liquidation values.

FIRM VALUATION (t = 0; k/€) Scenario

Risks 2021, 9, 105 18 of 36

Table 9. Alternative financing strategies and financial leverages.

Figure 10. Cont.

Risks 2021, 9, 105 25 of 36

Figure 11. Cont.

Risks 2021, 9, x FOR PEER REVIEW 27 of 36

Figure 12. Cont.

Figure 13. Cont.

Figure 14. Cont.

Risks 2021, 9, 105 32 of 36

Therefore, risk-capital measures are useful in defining financial policies aimed at

Funding: This research received no external funding.

Data Availability Statement: Not applicable.

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